Static Main Menu

Bank Rate Policy (BRP) used by a Central Bank

Article shared by :

ADVERTISEMENTS:

Read this article to learn about the bank rate policy (BRP) used by a central bank!

The bank rate is a traditional weapon of credit control used by a central bank. In order to perform its function as lender of last resort to commercial banks, it will discount first-class bills or advance loans against approved securities.

ADVERTISEMENTS:

A specific idea regarding the technique of bank rate can be had from the Reserve Bank of India’s definition of the bank rate policy which consists of varying the terms and conditions under which the market may have temporary access to the central bank through discounts of selected short-term assets or through secured advances.

Thus, the bank rate policy seeks to influence both the cost and availability of credit to members of the bank. Cost, of course, is determined by the discount rate charged, and the availability depends largely upon the statutory requirements of eligibility of bills for discounting and advances, as also the maximum period for which the credit is available.

The bank rate obviously is distinct from the market rate. The former is the rate of discount of the central bank, while the latter is the lending rate charged in the money market by the ordinary financial institutions.

The “Modus Operandi” of Bank Rate:

The bank rate policy signifies manipulation of the rate of discount by the central bank in order to influence the credit situation in the economy. The principle underlying the bank rate policy is that changes in bank rate are generally followed by corresponding changes in the money market rates, making credit costlier or cheaper, and affecting its demand and supply.

ADVERTISEMENTS:

If the bank rate is raised, its immediate effect is to cause an increase in bank’s deposit and lending rates. The prices which bankers are prepared to pay on the amounts deposited with them by their customers increase, so that the volume of the bank deposits increases.

Commercial banks employ a substantial proportion of the funds deposited with them to form the basis of loans and advances that they make to their customers, and in as much as the banks are now paying more for these deposits, they must charge higher rates for loans and advances made to their customers.

So when the central bank raises the bank rate, the cost of borrowing of the commercial banks will increase, so that they will also charge a higher rate for loans and advances made to their customers and, thus, the market rate of interest will go up.

This means that the price of credit will increase. As many business operations are normally conducted on the basis of bank loans, the price (interest) which has to be paid for this accommodation is, of course, a charge against profit to the business. In consequence, the sudden increase in the interest rate will reduce or wipe out the profit of the business, so that industrial and commercial borrowers reduce their borrowings.

ADVERTISEMENTS:

In other words, increased market rate or increase in the cost of borrowing will discourage business activity, i. e., and their demand for credit falls. As a result of the contraction of demand for credit, the volume of bank loans and advances is appreciably curtailed. This, in effect, will check business and investment activity so that unemployment will ensue.

Consequently, income in general will fall, people’s purchasing power will decrease and aggregate demand will fall. This, in turn, will affect the entrepreneurs adversely. When demand falls, prices will come down, and, as a result, profit will decline. The rate of investment is basically determined by the rate of profitability, and thus, in view of falling profits, investment activities will contract further. So, a cumulative, downward movement in the economy sets in.

In brief, an increase in the bank rate leads to a rise in the rate of interest and contraction of credit, which, in turn, adversely affects investment activities and consequently, the economy as a whole.

Similarly, a lowering of the bank rate will have a reverse effect. When the bank rate is lowered, the money market rates fall. Credit, then, becomes cheaply available and the business community will come forward to borrow more.

ADVERTISEMENTS:

Thus, the expansion of credit will increase investment activities, leading to an increase in employment, income and output. Aggregate demand will increase, prices will rise, and profits will increase which, in turn, will boost production and investment activities further. Consequently, a cumulative upturn of the economy will develop.